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Chapter 7
Perfect Competition
course, getting to the heart of market efficiency requires a careful explanation of what the “efficient” amount of a good or service means.
Private Markets: Benefits and Costs The main step in our examination of market efficiency is the valuation (in dollar terms) of benefits and costs. We begin the analysis with a single transaction and move on to the thousands of transactions that take place within markets. Consider the following example. THE DEMAND AND SUPPLY OF DAY CARE A couple is seeking to obtain up to 10 hours of day care per week for their 2-year-old. Through informal inquiries in their neighborhood, they have found a grandmother who has done baby-sitting and some day care in the past and comes highly recommended. The grandmother is not sure whether she is willing to commit to 10 hours. Before any discussion of price takes place, the couple has thought hard about their value for day care. They have decided that the maximum amount they are willing to pay is $8 per hour (that is, they would be indifferent to the options of getting day care at this price and not getting it at all). For her part, the grandmother has decided that her minimum acceptable price is $4. (Thus, $4 is the best estimate of her “cost” based on the value of her time and the strain of taking care of a 2-year-old. All things considered, she just breaks even at this price.) Can the couple and the grandmother conclude a mutually beneficial agreement? How can we measure the parties’ gains from an agreement? The answer to the first question clearly is yes. Any negotiated price between $4 and $8 would be mutually beneficial. What about the second question? If the parties are equally matched bargainers, we might expect the final price to be $6. The grandmother makes a profit of $2 per hour, or $20 per week. Similarly, the couple makes a $2-per-hour “profit”; that is, they pay only $6 for a day-care hour that is worth $8 to them. Their “profit” per week is $20. The couple’s gain (or any consumer’s gain in general) is customarily labeled consumer surplus. Although it goes under a different name, the couple’s gain is identical in kind (and here in amount) to the grandmother’s profit. Figure 7.5 makes the same point in graphical terms. The couple’s $8 value is drawn as a horizontal demand curve (up to a maximum of 10 hours per week). The grandmother’s $4 cost line and a $6 price line are also shown. The grandmother’s profit is depicted as the area of the rectangle between the price and cost lines. In turn, the couple’s consumer surplus is shown as the area of the rectangle between the value and price lines. The areas of the profit and consumer surplus rectangles are both $20. The total gain from trade—the sum of consumer surplus and profit—is given by the area of the rectangle between the value and cost lines and comes to $40.
